Should Derivitives Markets Be Regulated?

[adios]

My understanding is that there's lots of trading of interest rate hedging derivitives likes swaps and caps. For one I know Fannie and Freddie use them. I lot of mortgage backed securities are issued (it's a bigger market than US treasuries) that have derivitives utilized in the securitization process. My understanding is that there is no regulation of these markets for interest rate hedging derivitives. Should there be? Not completely sure what regulation could do to insure that some sort of meltdown doesn't take place.

[adios]

Though not specifically referring to regulating derivitives markets, this editorial about Fannie Mae is really about derivitives since Fannie Mae makes such extensive use of them. I'd definitely recommend going to Fannie Mae's website and reading about their business model.

Fannie Mae Website (http://www.fanniemae.com/index.jhtml)

Anyway on the web site they explain their extensive use of derivitives their much better than I can if your interested. I wouldn't invest in Fannie Mae personally due to the amount of analyst coverage. Why would I have more knowledge than the collective knowledge of upteen analysts and an untold number of savvy investors? Here's the WSJ editorial:

Fannie's Black Box

How much evidence do we need? Wednesday's news that Fannie Mae has had to revise its balance sheet by $1.1 billion is just one more sign that the government-sponsored mortgage giant and its brother, Freddie Mac, need to be examined from stem to stern.

Fannie pooh-poohed the accounting error yesterday with her usual insouciance, attributing it to "honest mistakes made in a spread sheet." The restated figures didn't alter the company's third-quarter profit.

To which we say, get real. This is the third time in about a year that Fannie or Freddie has jolted the market with an accounting problem. September of last year saw a widening of Fannie's "duration gap" -- a measure of how successful its interest-rate risk is hedged -- and a 3% drop in the share price. Freddie is still sorting out an accounting scandal that cost the jobs of its CEO, CFO and president. Now this.

The basic problem is that the duo's operations are essentially a black box, with no one quite sure how they are juggling all of their enormous risk. It is too dangerous for a modern economy to have so much financial risk contained in two companies that have an implicit taxpayer guarantee -- especially without adequate regulatory scrutiny.

Congress now has one more reason to embrace Representative Richard Baker's plan to bring the pair under Treasury supervision. So far Fannie and Freddie have blocked this with their usual political intimidation. But Members might start thinking about how they'll explain themselves if they do nothing and the next Fannie or Freddie surprise is ugly.

Updated October 31, 2003

Personally I think the stakes are high here. There is no doubt that securitization of real estate loans has been a boon to the real estate industry. Furthermore Fannie has been a big part of that securitization story. On top of that real estate is key component of the US economy. I think I'm on fairly safe ground in stating that refinancing and home equity has made the economic slowdown over the past three years fairly mild in that the consummer has remained fairly strong. If congress hurts real estate loan liquidity through over regulation and stupid regulation of Fannie (and Freddie too), that could have very negative effects on the economy IMO. However, if some blow up in the derivitives markets, that could have been prevented with prudent regulation, comes to pass that could also have serious economic consequences.

[Wildbill]

Tom,

While it's a nice idea on paper and sure who wouldn't want better oversight of it, I think derivatives are near impossible to regulate. Most deals aren't publicized and are dreamed up often in an investment bank office. Where derivatives go wrong is when someone gambles too much on them, at their core they are simply a risk management tool and that is what Fannie Mae does with its derivatives. They aren't going out and gambling much. Hedge funds do gamble and they are the ones that have and could continue to get into trouble.

At the heart of the problem though is how exactly do you watch these things? Most aren't traded on the public market and are not subject to visible pricing and liquidity. Without those its impossible to say what you could do. Regulating them would be akin to virtually shutting down much of the activity because you would have to take instant decisions done for billions of dollars and put some disclosure and pricing and whatever else demands on them and that would just chase the business away. My guess is if they did do some good regulating a lot of the business would go offshore to somewhere that it wasn't regulated. Bermuda and the Bahamas would get the business and that isn't exactly what we want these days.

[Cyrus]

IMHO, it's not the derivatives market per se that should be regulated. It's the way derivatives affect balance sheets and income statements that needs to be streamlined and the process made more transparent.

The derivatives market itself is practically impossible to regulate, even if we were to agree on what exactly we mean by "regulation". /images/graemlins/smirk.gif

Besides, if you are talking about regulation in the US only, without some global consent, which is always tough, there's always the Euromarket, which, for interest rate products turns over about half the world's trading, at abt $84tr/qtr.

[adios]

Thanks for your comments Cyrus and I appreciate your take here. You make some very good points methinks. As far as what I mean by regulation, I'll cite one example interest rate swaps and compare them to a derivative that is regulated, options. My understanding is that the interest rate swaps market if you will is huge. Furthermore, my understanding is that regulation in the form of clearing houses, SEC oversight, exchanges, etc. that you find with options markets do not exist for the interest rate swaps market.